The Sarbanes-Oxley Act of 2002 and Capital Market Behavior Early Evidence by Jain and Rezaee (2006...

I The Sarbanes-Oxley Act of 2002 and. Capital-Market Behavior: Early Evidence*

PANKAJ K. JAIN, University of Memphis

ZABIHOLLAH REZAEE, University of Memphis

AbstractThe Sarbanes-Oxley Act of 2002 ("the Act") was enacted in response to numerous corporateand accounting scandals. It aims to reinforce corporate accountability and professionalresponsibility in order to restore investor confidence in corporate America. This study exam-ines the capita!-market reaction to the Act and finds a positive (negative) abnormal return atthe time of several legislative events that increased (decreased) the likelihood of the passageof the Act. We interpret this finding as evidence supporting the notion that the Act is wealth-increasing in the sense that its induced benefit.s significantly outweigh its imposed compliancecosts. We also find that the market reaction is more positive for firms that are more compli-ant with the provisions of the Act prior to its enactment.

Keywords Corporate govemance; Financial scandals; Market reactions; Sarbanes-OxleyAct of 2002

JEL Descriptors G14,G28,M4i

La Loi Sarbanes-Oxley de 2002 et le comportement du marche boursier :premieres constatations

CondenseLes auteurs examinent les repercussions de la reglementation sur la richesse des actionnaires.La vague de scandales financiers de la fin des annees 1990 et du debut des annees 2000 aravive le debat sur ta reglementation de la gouvernance d'entreprise et de la professioncomptable. Les inquietudes suscltees chez les investisseurs par ces scandales et la perte deconfiance qu'ils ont provoquee sont frequemment evoquees comme principales raisons deI'effondrement du marche boursier en 2002 (Browning et Weil, 2QQ2). Ces scandales contri-buent a expliquer I'affirmation des legislateurs et des autorit^s de r6glementation selonlaquelle « on ne saurait compter sur le fonctionnement autonome des marches boursiers,sans un sollde encadrement reglementaire, et la nouvelle reglementation s'imposait pourrestaurer la confiance des investisseurs » (Ribstein, 2002 [traduction]). Afin de restaurer la

Accepted by Peer Clarkson. We are grateful for suggestions from Rashad Abdel-Khalik, TenyShevliti. Hassan Tehranian, Lynn Turner. James Up.son. Mohan Venkatachalam. :ind the editors,Gordon Richardson and Peter Clarkson.

Contemporary Accounting Research Vol. 23 No. 3 (Fall 2006) pp. 629-54 © CAAA

630 Contemporary Accounting Research

confiance et de renforcer ['obligation de rendre compte et la responsabilit^ professionnelledes entreprises. le Congres americain adoptait la Loi Sarbanes-Oxley (ci-apr^s la Loi) enjuillet 2002. Cette loi avait pour but d'ameliorer la gouvemance d'entreprise, d'accroTtrela qualite des rapports financiers, de promouvoir Tefficacite de la veritication. de crêr lePublic Company Accounting Overslgbt Board (PCAOB) pour reglementer la professionde verification, et d'accroitre la responsabilite crlminelle et civile des contrevenants aux loisregissanl les valeurs mobiiiferes.

La Loi porte sur la conduite el la responsabilite professionnelle des personnes quiproduisent, certifient, v^rifient. analysent et utilisent Tinformation tinanciere que publient lesentreprises. La Loi est interpretee conime etant« un effort, destine a corriger les extemalitesdu marcbe, d'une ampleur equivalente a celle de toute legislation adoptee par le gouvemementfederal dans I'bistoire recente [...j elle vise la fagon d'agir des gens, et non la destinationdes valeurs mobilieres » (Wiesen, 2003, p. 429 [traduction]). Les preuves empiriques (CRA,2005 ; Turner, 2005) revelent que. si la Loi a procure aux investisseurs des avantages appre-ciabies. elle a egalement impose des couts de conformite importants. Ces couts represententpour les societes ouvertes environ 0.1 pour cent de leur chiftre d'affaires total. Les auteursetoffeni le debat de donnees issues d'une analyse des repercussions de la Loi sur la Hchessedes actionnaires ei des determinants possibles de ces repercussions.

Le but de la presente etude est double. Premierement, les auteurs examinent lesrepercussions de la Loi sur la ricbesse des actionnaires. Us etudient les reactions du marcbefinancier a plusieurs mesures, prises par le Congres. qui out mene a l'adoptioii de cette Loi.Deuxi^mement, ils se demandent si les attributs propres a Tentreprise {fonctions de gouver-nance. d'information financiere et de verification) sont a.ssocies aux reactions du marcbeobservees. Comme de precedents cbercheurs (Espahbodi, Espabbodi. Rezaee et Tehranian.2002 ; Ali et Kallapur, 2001). les auteurs utilisent de multiples sources pour d^finir douzemesures legislatives importantes ayant mene a Tadoption de la Loi. En s'inspirant de lastrategie utilisee par SchipperetTbompson (1983) et par Ali el Kallapur (2001). ils classentces douze mesures en trois categories, selon la probabilile qu'elles modifient les attentesrelatives a I'adoption de la Loi : I) les mesures ambigues dont l'incidence sur la probabilityestimee d'adoption de la Loi est soit nulle. soit neutre. 2) les mesures ddfavorables quidiminuent la probabilite estimee d'adoption de la Loi et 3) les mesures favorables quiaugmentent la probabilite estimee d'adoption de la Loi.

Les auteurs prevoient que les marches financiers auront reagi de faôn positive auxmesures legislatives qui augmentent la probabilite d'adoption de la Loi et que cette reactionsera plus accentuee dans le cas des societes deja dotees, avant I'adoption de la Loi. defonctions de gouvemance, d'information financiere et de verification plus efficaces. La Lois'applique a toutes les societes faisant appel public a I'epargne. Par consequent, les auteurss'attendent a ce que le marcbe boursier dans son ensemble ait rdagi de faôn positive(negative) aux mesures favorables (defavorables), dans la periode entourant I "adoption de laLoi. Le test initial des auteurs porte sur deux indices boursiers diversifies, soit I'indiceS&P 5(X) et I'indice Value-Line a ponderation equivalente. Le test des mesures s'^cbelonnede fevrier h juillet 2002. Pour cbaque indice. les rendements anorniaux dans la periodeentourant les mesures en question sont calcules a I'aide du module de rendement moyenconstant. La periode d'estimation dans le cas du rendement normal (rendement de reference)commence 142 jours de bourse avant le 2 fevrier 2002 et se termine 21 jours de bourse avant

CAR Vol. 23 No. 3 (Fall 2006)

The Sarbanes-Oxley Act of 2002 and Capital-Market Behavior 631

cette date. Les auteurs calculent ensuite les rendements anormaux jour-mesure (AR) ensoustrayant le rendement normal du rendement brut du jour. 11s obtiennent les rendemenlsanormaux cumulatifs sur troi.s jours {CAR) en additionnant les rendements anormaux dujour de la mesure, du jour pr^cedant la mesure et du Jour suivant la mesure. Les auteursprocedent a une analyse transversale afin de determiner les caracteristiques propres aTenireprise qui influent sur I'ampleur de la reaction des cours boursiers aux mesures duCongres qui augmentent la probability d'adoption de la Loi. Cet exercice livre de Pinforma-tion concluante en ce qui a trait aux determinants des repercussions de la Loi sur la richessedes actionnaires.

Les auteurs rel&vent un rendement anormal positif (negatif) a la date de plusieursmesures legislatives qui augmentent (diminuent) la probabilite d'adoption de la Loi. L'analysedes mesures realisee par les auteurs a I'^chelon des portefeuilles revele que les marchesboursiers ont eu une reaction positive aux mesures du Congres qui ont mene a Tadoption dela Loi en creant des extemalites positives {augmentation de la confiance des investisseurs).Les conclusions des auteurs viennent etayer la perception generale seton laquelle la Loiatteint le but vise, soit de resiaurer la confiance des investisseurs. Cette constatation donne apenser que la Loi a cree un environnement favorisant une solide integrite du marche et queles investisseurs ont accueilli favorablement son adoption. Les auteurs jettent egalement uneclairage sur les determinants de la reaction observee du marche, a I'aide des variables propresaux entreprises. 11s constatent que la Loi a eu une incidence plus positive sur les entreprisesqui se conformaient mieux aux prescriptions de la Loi avant meme l'adoption de cette demiere— grace a une gouvemance plus efficace, des rapports financiers fiables et transparents, etune fonction de verification plus credible — que sur les autres entreprises. Les auteursnotent que la Loi a, en moyenne. favorise Taugmentation de la richesse et que la reaction dumarche a ete plus positive pour les entreprises dont le mode de fonctionnement se confomiaitdavantage aux exigences de la Loi (conformite mesuree selon les fonctions de gouvemanced'entreprise, d'information financiere et de verification), avant meme ["adoption de cettedemidre.

Les resultats de I'^tude r^sistent au controle d'autres attributs des entreprises commeceux de la taille, de la performance, des honoraires de verification et du levier financier. Cesresultats ont des consequences pour les soci^tes ouvertes, les investisseurs, les chercheurs etles responsables de I'elaboration des politiques. Selon une interpretation des constatationsdes auteurs. meme si toutes les entreprises beneficient egalement de la Loi, cette demifereimpose des couts de conformite sup^rieurs aux entreprises dont la gouvemance laisse adesirer et dont les normes d'information sont moins rigoureuses. La Loi a eu pour effet destimuler les initiatives visant a r^tablir la confiance des investisseurs dans les fonctions degouvemance d'entreprise. d'information financiere et de verification. Dans I'ensemble, lesresultats de I'etude portent a croire que les avantages de la Loi excedent de beaucoup lescouts de conformite qu'elle impose, si Ton en juge par les cours boursiers.

1. Introduction

The wave of financial scandals in the late 1990s and the early 2000s has reinvigo-rated the debate on regulating corporate governance and the accounting profession.Investors' concerns about these scandals and the resulting loss of confidence arecommonly cited as primary reasons for the stock-market slump in 2002 (Browning



and Weil 2002). To restore investor confidence and reinforce corporate account-ability and professional responsibility. Congress passed the Sarbanes-Oxley Act("'the Act") in July 2002. The Act is aimed at improving corporate governance,enhancing the quality of financial reports, promoting audit effectiveness, creatingthe Public Company Accounting Oversight Board (PCAOB) to regulate the audit-ing profession, and increasing criminal and civil liability for violations of securi-ties laws. The Act addresses the conduct and professional accountability of thosewho produce, certify, audit, analyze, and use public financial information. The Actis considered "as broad an attempt to correct free-market externalities as any legis-lation passed by the federal government in recent memory ... it deals with whatpeople do. not where securities go" (Wiesen 2003, 429). Anecdotal evidence(Charles River Associates [CRAJ 2005; Turner 2005) indicates that although theAct has induced significant benefits to investors, it has also imposed substantialcompliance costs. These costs for public companies are about 0.1 percent of totalrevenues. This study contributes evidence to this debate by investigating share-holder wealth effects of the Act and possible determinants of such effects.

The purpose of this study is twofold. First, it examines the effect of the Act onshareholder wealth. We investigate the capital-market reactions to several congres-sional events leading up to its enactment. Second, it investigates whether firm-specificattributes (corporate govemance. financial reporting, and audit functions) are asso-ciated with the detected market reactions. We detect a positive (negative) abnormalreturn at the time of several legislative events that increased (decreased) the likeli-hood of the passage of the Act. Our portfolio-level event analysis reveals that thecapital markets reacted positively to congressional events leading up to the passageof the Act by creating positive externalities (improvement in investor confidence).The results support the general perception that the Act is achieving its intendedpurpose of restoring investor confidence.' We find that the Act is wealth-increasing,on average, and that the market reaction is more positive for firms that were closerto compliance to the Act (measured by their corporate governance, financialreporting, and audit functions) prior to its enactment. Our results are robust aftercontrolling for otber firm attributes such as size, performance, audit fees, and lever-age. The results of this study have implications for public companies, investors,researchers, and policymakers.

The remainder of the paper proceeds as follows. The next section reviews therelated literature. A discussion of possible shareholder wealth effects of the Act,the events leading to the passage of the Act, and the hypothesis development arepresented in section 3. Section 4 discusses our research design. Results are pre-sented in section 5, and section 6 concludes the paper.

2. Related research

Two contemporaneous studies examine the effects of the reported financial scan-dals and the congressional responses (the Act) on investor confidence. Cohen. Dey,and Lys (2004) document that earnings-management activities of public compa-nies increased substantially during the financial scandal period. This trend reversedfollowing the passage of the Act, which indicates that increased eamings manage-



ment contributed to the erosion of investor confidence, and the Act led to the resto-ration of that confidence. Jain, Kim, and Rezaee (2004) find: (a) wider spreads,lower depths, and higher adverse-selection components of spreads during thefinancial scandal period, causing a deterioration of market quality: and (b) evi-dence indicating improvements in market liquidity measures after the passage ofthe Act both in the short and the long term.

Three related studies (Li, Pincus, and Rego 2004; Engel, Hayes, and Wang2004; Zhang 2005) were conducted after our initial study. Li et al. find that the Acthas a net beneficial effect of improving the quality of financial reports whileimposing greater costs on firms that were less compliant with its provisions regard-ing auditor independence, audit committee role, and earnings management. Engelet al. find that the detected abnormal return surrounding events that increased thelikelihood of the passage of the Act were positively associated with the firm's sizeand share turnover, suggesting that compliance costs were more burdensome forsmaller and less liquid firms, which in turn caused many of them to go private.Zhang documents overall negative market reactions to many legislative events per-taining to the Act in the sense that investors view the implementation of provisionsof the Act — including restriction of nonaudit services, enhanced corporate gover-nance, and internal control reporting — to be costly to businesses. Although therelated research provides insights into the effects of regulations on capital markets,earnings-management activities, compliance costs, and market liquidity, it does notaddress the determinants of such effects, including firm-level issues of corporategovemance, financial reporting, and audit functions.

3. Shareholder wealth effects of the Act

The process and rationale underlying the legislation

The wave of financial scandals in the early 2000s encouraged lawmakers andregulators to argue that capital markets could not be trusted "to work on their ownwithout strong regulatory support and [thus] new regulation was needed to restoreinvestor confidence" (Ribstein 2002). Consistent with prior research (Espahbodi,Espahbodi, Rezaee, and Tehranian 2002; Ali and Kallapur 2001), we use multiplesources to identify the significant legislative events leading up to the passage ofthe Act. To identify key events, we began by searching the Securities andExchange Commission (SEC) and congressional websites and looked for pressreleases pertaining to the Act. We next searched the Wall Street Journal index(WSJI), the Wall Street Journal (WSJ), and the New York Times (NYT) to confirmand/or identify the event dates.2 Each of the 12 identified events potentially informinvestors of the likelihood of the passage of the Act and its possible impact on cor-porate governance, financial reporting process, and audit functions. Followingthe strategy used by Schipper and Tbompson 1983 and Ali and Kallapur 2001, weclassify these 12 events into three categories based on their likelihood to alterexpectations about the passage of the Act: (a) ambiguous events that had eitherno effect or a neutral effect on the Act's assessed probability of enactment, (b) unfa-vorable events that decreased the Act's assessed probability of enactment, and



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(c) favorable events that increased the Act's assessed probability of enactment, asdiscussed in the following sections. Figure 1 illustrates the time-line of these legis-lative events, along vt'ith their anecdotal evidence, provisions, and our predictionsof possible security price reactions.

Ambiguous events

Legislators and regulators initially attributed reported financial scandals of theearly part of 2002 (Enron, Global Crossing, Adelphia) as "a few rotten apples"requiring no regulatory responses (Cunningham 2003). During this period, inves-tors were frustrated with the wave of financial scandals, yet they either were notconvinced of the widespread effects of scandals or considered them unrelatedevents, as evidenced by a relatively stable investor confidence index around a valueof 85 (U.S. General Accounting Office [GAO] 2002). Revelations of further corpo-rate and accounting scandals started in March 2002, continued through June, andwere galvanized with the SEC complaint against WorldCom on June 26,2002. Thereported financial scandals in May and June 2002 caused the UBS/Gallup indexfor investor confidence to decline to an all-time low of 46 in June (GAO 2002).

During this period of ambiguity, more than 30 reform bills were introduced bylegislators and regulators (Schroeder 2002). In essence, there were three competingrefonn proposals. Senator Paul Sarbanes, Democratic chair of the Senate BankingCommittee, sponsored a bill that would (a) impose tougher rules on the accountingprofession and financial analysts, (b) boost the budget of the SEC and strengthenits power to discipline corporate executives, and (c) create an oversight board withbroad powers to oversee audit functions. This bill was viewed as a sensible regula-tion but was strongly criticized as being too prescriptive. The second proposedreform was a Republican bill sponsored by Congressman Michael Oxley that wouldcreate an independent audit oversight board, similar to that proposed by Sarbanesbut with far fewer powers. This bill was viewed as a regulation with no teeth andan enshrinement of the status quo. The third proposal was the SEC's plan for a pri-vate regulatory board to regulate public accounting firms. During this ambiguousperiod of intensive legislative debate, market participants received conflictingsignals from tbe House, the Senate, the SEC, and the White House regarding thecontent, substance, and likelihood of the passage of any congressional refonn.Thus, we do not make predictions for the three legislative events during the ambig-uous period.

Unfavorable events

Two versions of the reform bill received congressional attention and public sup-port. The Republican-backed House bill (Oxley) was favored by the accountingprofession and considered by many as a weaker reform. The tougher bill proposedin the Senate (Sarbanes) was viewed as being too prescriptive and harsh to thefinancial community and corporations. There were, however, considerable uncer-tainties over which one would prevail and whether either one would be passed byCongress (Geewax 2002a). The Senate considered the Sarbanes bill in the first weekof July 2002. President Bush made a highly publicized speech to Wall Street on



July 9, 2002, which was viewed by many as simply tinkering with the SEC planfor a private regulatory board and other proposals to regulate public accountingfirms (Kulish 2002). The extent of disagreements between the Senate and theHouse bills, the limited time to compromise on these differences in the Hrst part ofJuly 2002, and the ineffectiveness of the president's proposal created significantdoubt that any reform bill would pass before Congress departed Washington for theAugust recess (Geewax 2002a; Oppel 2002). The possibility of the passage of ameaningful reform bill was remote, primarily because "lobbyists and some leadingRepublicans had pledged to rewrite the bill when it got to conference committee"(Oppel 2002, AI). We posit that investors perceived these differences as a signal ofa decreasing likelihood of the passage of the Act (events of July 9, 15, 16, and 19,2002), and thus we predict negative market reactions to these events.

Favorable events . ' , ^

The Act emerged under circumstances that virtually ensured its passage in the lastweek of July 2002. First, because 2002 was a mid-term election year. Democratsused reported financial scandals as an opportunity to push for a broader regulatoryagenda. Second, the pervasiveness of reported financial scandals made it difficultand risky for any politician, particularly pro-business Republicans, to block its pas-sage especially after a July 24 Conference report of a joint House-Senate commit-tee received approval. Third, the bill was finally renamed the Sarbanes-Oxley Act bythe Conference committee on July 24 and included a majority of provisions fromthe perceived tougher Senate bill, which made the Act a symbolic victory for Dem-ocrats. Fourth. President Bush said on July 24 that "he would .sign the Sarbanes-Oxley Act of 2002, which he called a victory for America's shareholders andemployees" (Geewax 2002b). Finally, Congress moved rather swiftly to pass theAct after the wave of financial scandals eroded investor confidence in the capitalmarkets. Fvents pertaining to the Conference report on July 24, the congressionallegislation on July 25. 2002, sending the compromised bill to the president on July26, 2002, and all rumors about the president signing the compromised bill sentsignals to the market suggesting the increasing likelihood of the passage of the Actand the resolution of uncertainty about its provisions. We posit that investors viewedthese events as favorable, and the capita! markets reacted to them positively.

Theoretical argument and hypothesis development

In this section, we describe the theoretical argument that motivates our hypothesisdevelopment and empirical analysis. The Act provides a compelling setting forassessing the shareholder wealth effects of mandatory disclosure and corporategovemance regulations for several reasons. First, the Act applies equally to, and isintended to benefit, all publicly traded companies. Some of the provisions of theAct, which were not previously practiced by public companies, and which areintended to benefit all companies, are (a) creating the PCAOB to oversee the audit ofpublic companies and to improve the perceived ineffectiveness of the self-regulatoryenvironment for the auditing profession; (b) improving corporate governancethrough more vigilant boards of directors and responsible executives; (c) enhanc-



ing the quality, reliability, transparency, and timeliness of financial disclosuresthrough executive certifications of both financial statements and internal controls;(d) prohibiting nonaudit services; (e) regulating the conduct of auditors, legalcounsel, and analysts and their potential conflicts of Interest; and (f) increasingcivil and criminal penalties for violations of security laws.

Second, the mandatory level of compliance with the provisions of the Actregarding corporate governance, accounting, and auditing practices is presumablymuch higher than the previously practiced level. Third, the Act is intended toimprove investor confidence, and its provisions are designed to reduce the informa-tion risk perceived by the capital market about the true cash flows of the companies.A reduction in the risk premium reduces the discount rate that the investors use toevaluate companies. Thus, we predict that stock prices will respond to legislativeevents leading up to the passage of the Act. Although the direction of capital-marketreactions to these events is an empirical issue, consistent with Espahbodi et al.2002, we formulate our first hypothesis as follows:

HYPOTHESIS 1. The capital markets reacted positively (negatively) to legislativeevents that increased (decreased) the likelihood of the passage of the Act.

The overall benefit induced by the Act — that is, improving investor confi-dence — must be weighted with the imposed compliance costs at the firm-specificlevel. Brown and Caytor (2004) find that good (poor) corporate governance is asso-ciated with higher (lower) profits, less (more) risk, less (more) stock price volatility,higher (lower) values, and larger (smaller) cash payouts. Gompers, Ishii, and Met-rick (2003) document that firms with stronger corporate governance experiencedhigher stock returns than those with weaker corporate governance during the1990s. The Act requires a poor (good) governance firm to make many (few)changes to its pre-Act governance structure. Thus, compliance with provisions ofthe Act pertaining to corporate governance, financial reporting, and auditing func-tions would be more costly to poor governance firms than to good governancefirms. Indeed, recent surveys show that the costs of compliance with the Act rangefrom as little as SI million to as high as over $10 million (Business Roundtable2004). Zhang (2005) estimates that the cost of compliance with section 404 of theAct ranges from 0.12 percent to 0.62 percent of a company's reported revenues,and the average is tower in terms of percentages for larger companies.

We assume that all public companies affected by the Act were in equilibriumin the pre-Act period. The Act raised the stock price valuation for all firms byimproving investor confidence in tbe capital markets, a pure externality effect thatis not firm-specific. For more compliant (MC) firms, ex ante, the induced benefitsoutweighed the imposed costs, whereas, for less compliant (LC) firms, ex ante, theimposed compliance costs outweighed the induced benefits. Nonetheless, LC firmsmay still show positive abnormal retums because the positive pure externality(induced by improvement in investor confidence) outweighs the excess of costsover benefits. MC firms, on the other hand, are expected to show even higher posi-tive abnormal retums because of the positive pure extemality effect without any



major setback on the cost front.^ As with any regulations, shareholder wealtheffects of the Act are a function of both the expected benefits and costs imposed onpublic companies. Our second hypothesis therefore is as follows:

HYPOTHESIS 2. The observed positive capital-market reactions are higher(lower) for firms with more (less) effective corporate governance, finan-cial reports, and audit functions prior to the passage of the Act.

4. Research design

Test of Hypothesis 1 (time-series analysis)

The Act is applicable to all publicly traded companies. Therefore, we expect thecapital market as a whole to react positively (negatively) to the favorable (unfavor-able) events around the passage of the Act, as discussed in the previous section.Our initial test focuses on two broad-based market indexes — namely, the Stan-dard & Poor's (S&P) 500 index and the Value Line equally weighted index. Thetest period for our events is from February to July 2002. For each index, abnormalreturns around the relevant events are calculated using the constant-mean returnmodel. The estimation period for the normal (benchmark) return starts from 142trading days before February 2, 2002 and ends 21 trading days before that date.The event-day abnormal returns (ARs) are then calculated as the day's gross returnminus the normal return. The 3-day cumulative abnormal returns (CARs) areobtained by adding the abnormal returns on the event day, one day before theevent, and one day after the event.**

We also examine the solitary and aggregate impacts of 12 congressionalevents on stock prices using a times-series model based on Ali and Kallapur 2001and Espahbodi et al. 2002, as follows:

12PjDj + ej .' (1),

where Rf is average daily stock return of sample firms on date t; a^, is the interceptcoefficient that represents the average daily stock return across the 485 noneventtrading days in 2001 - 2 for the S&P 500 portfolio; /3y represents mean-adjustedreturns of the portfolio retum for event; minus the portfolio mean return over thenonevent days; D. is a dummy variable that takes a value of I for the event window(r = - 1 . r == 0, / = +1) relative to the announcement date of event j , and 0 other-wise; and e: is random disturbance, which is assumed to be normal and indepen-dent of the event.

We estimate (1) over the 485 trading days of stock retum data for 2001 and2002 using raw returns for S&P 500 firms. Unlike Espahbodi et al, 2002, we didnot adjust (1) for market return because the Act was intended for ali public com-panies and the entire market is affected by the Act. We also estimate (, I) for ourthree event classifications: (a) ambiguous events period (events 1-4, 91 trading



days); (b) unfavorable events period (events 5-8,9 trading days); and (c) favorableevents period (events 9-12, 4 trading days). We also estimate (1) for (d) all con-gressional 12 events (events 1-12, 115 trading days).

Test of Hypothesis 2 (cross-sectional analysis)

We perform a cross-sectional analysis to Identify the firm-specific characteristicsthat influence the magnitude of stock price reactions to congressional events thatincreased the likelihood of the passage of the Act. Our cross-sectional analysisprovides evidence pertaining to the determinants of shareholder wealth effects ofthe Act.

Dependent variable

We use the standard event study methodology for the cross-sectional analysis toestimate abnormal retums (AT?,,) as follows:

ît = fî,-fif-P*if^M,'f^f) (2),

where Rj, is the return on stock / on event date /; ^ is the stock's beta, which mea-sures the sensitivity of a company's stock price to the fluctuation in the S&P 500index, calculated for a five-year period ending in June 2002 using month-end clos-ing prices including dividends; Rjr is the risk-free rate of retum from treasury bills(T-bills); and Rj^, is the retum on S&P 500 index on the event date. The dependentvariable for our second regression is cumulative abnormal retums (CA/?,,), whichis obtained by adding the abnormal retums on the event date, one day before theevent, and one day after the event.

Test variables

Provisions of the Act are expected to affect three fundamental attributes of publiccompanies: corporate govemance. financial reporting, and audit functions. We usethe three S&P transparency and disclosure (T&D) dimensions of corporate gover-nance ownership structure and investor rights (OSIR). board and managementstructure and process (BMSP), and financial transparency and information disclosure(FTfD\ along with other explanatory variables, in our cross-sectional analysis. Thegoal of this analysis is to determine the relation between the observed capital-marketreactions and firms' financial attributes and corporate govemance characteristics.

Measures of corporate governance

Corporate govemance addresses the potential conflicts of interest and agency prob-iems induced by the separation of ownership and control in corporations (Famaand Jensen 1983). These agency problems may cause conflicts of interest andinfonnation asymmetry, which can be costly to shareholders. The Act changes thebalance of power between directors, executives, and investors by shifting signifi-cant responsibilities from management to the audit committee. These changes areexpected to motivate corporate boards, audit committees, and executives tobecome more vigilant, transparent, and accountable toward financial reports.'' We


Tbe Sarbanes-Oxley Act of 2002 and Capital-Market Behavior 641

posit that firms with higher corporate governance scores (OSIR and BMSP) aremore positively affected by the Act.

Measures of financial reporting

Many provisions of the Act are aimed at improving the quality, transparency, andreliability of financial reports from public companies (for example, executive cer-tifications of financial statements and internal controls). We use two measures offinancial reporting: (a) S&P T&D scores for financial transparency and disclosure{FTID), and (b) the absolute value of total accruals {ATAC) as proxies for the qual-ity, reliability, and transparency of financial reports. We predict that firms withhigher FTID scores are more positively affected by the Act. Prior research (Cohenet al. 2004; Frankel, Johnson, and Nelson 2002) uses magnitude and signs ofaccruals as a proxy for eamings quality In the examination of eamings management.Thus, we expect a negative relation between the ATAC and the observed marketreactions to the Act.

Measures of audit functions

Several provisions of the Act are aimed at improving audit quality, effectiveness,and credibility, including auditor independence, retention of audit evidence, andoversight of the PCAOB. The Act, by reducing management's influence on audittenure and prohibiting nonaudit services, can reduce conflicts of interest betweenmanagement and auditors, which in tum can improve audit credibility and quality.We use the ratio of nonaudit fees to total auditor fees as a proxy for the credibilityof audit functions and predict a negative relation between this ratio and theobserved capital-market reactions to the Act. Prior research (e.g.. Chaney and Philip-ich 2002) documents that Arthur Andersen clients experienced negative abnormalreturns over a period of negative news disclosure about Enron and Andersen. Thus,we use an Arthur Andersen {AA) variable as a proxy for auditor's reputation andcredibility, and predict a negative relation between the AA variable and theobserved capital-market reactions to the Act.

Control variables

We control for several equity characteristics (firm size, performance, and leverage)that have been documented in prior research (e.g., Fama and French 1993) as beingassociated with securities retums. We control for firm size using market capitaliza-tion. Large firms often have more resources and are better equipped to absorb thehigh compliance costs of the Act, and thus we predict the coefficient on size vari-able to be positive. We control for firm performance (risk and expected growth)using the market-to-book ratio of common equity (Fama and French 1993), andexpect this variable to be positive. We control for financial leverage by using debt-to-equity ratio. The agency theory (Jensen and Meckling 1976) suggests that fimishave more incentive to offer increased levels of monitoring when leverageincreases. Thus, highly leveraged firms are more likely to benefit from monitoringmechanisms provided by the Act in order to ensure compliance with the restrictivecovenants specified in debt agreements. We predict a positive relation for leverage.

CAR Vol. 23 No. 3 (Fail 2006)


We also control for the cost of compliance with provisions of the Act. As discussedin section 3, the cost is higher for less compliant firms than for firms that are morecompliant prior to the passage of the Act. We use audit fees as a proxy for the costof compliance with the Act because audit fees are estimated to constitute a largeportion of the total compliance costs. We predict a negative relation between theaudit fee variable {AUT) as a proxy for the compliance cost and the observed capi-tal-market reactions to the Act.

Regression models

We developed our regression model, which is based on cross-sectional variables,as follows:

CARj, - a + ^lOSIRi, + ^j^MSPj, + ^^^FTIDi, + PÂTAC^ + ^sNATAj,

+ ^jMACi, + p^MTBj, + fi^Vi, + PioAUTi, + €,, (3).

Our sample for the cross-sectional analysis consists of 415 S&P 500 firmswith available data on test variables (40 firms were excluded for nonexistence ofS&P and T&D scores, and another 45 were excluded for unavailability of data onauditor fees). The presence of tbe cross-sectional beteroscedasticity and tbe con-temporaneous correlation of the residuals are likely in our data primarily becausecongressional events leading to tbe passage of the Act affect all sample firms. Weemploy the generalized method of moments (GMM) estimation, which uses a cor-rect variance-covariance matrix based on residuals, to address the economic issuesrelated to heteroscedastic or correlated error terms. Panel A of Table I defines alltest and control variables, and provides descriptive statistics (mean, median, standarddeviation, minimum, maximum) for them, and panel B reports correlations betweenthe variables.

5. Results

Time-series analysis

Table 2 reports the observed daily abnormal retums (ARs) and tbree-day cumula-tive abnormal retums (CARs), along with their predicted signs, around eacb of the12 events and for each of the three event periods designated as ambiguous, unfa-vorable, and favorable. Of the eight dates for which we predict whether the eventwill increase or decrease the likelihood of the passage of the Act, the sign of thedaily abnormal return conforms to our prediction for seven dates. Columns 5 and 6of panel A present the ARs and tbree-day CARs results of the Value Line index.ând columns 7 and 8 show ARs and CARs based on the portfolio of 500 firms inthe S&P 500 for each of the 12 events. Panel B of Table 2 presents average dailyabnormal retums (ADAR) for both models for eacb of the three categories of tbeevents and the aggregate impact of all events. Column 3 shows ADAR for the ValueLine index, and column 4 presents ADAR for tbe portfolio of S&P 500 stocks.

We generally detect negative capital-market reactions to ambiguous events,particularly event number 3 regarding the SEC's plan for a private regulatory board


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Notes:

Variables are defined as follows:

OSIR = S&P's composite scores for ownership structure and investor rights as of June 30,2002, ranging from 1 to 10;

BMSP = S&P's composite scores for board and management structure and process as ofJune 30, 2002, ranging from 1 to 10;

FTID = S&P's composite scores for financial transparency and information disclosure asof June 30, 2002. ranging from 1 to 10;

ATAC = the absolute value of total accruals, equal to net income minus cash flows fromoperations, deflated by average total assets for the fiscal year ended December2001;

NATA ^ the ratio of nonaudit fees to total auditor fees for the fiscal year ended December2001;

AA = an indicator variable that takes a value of I if firm's financial statements for fiscalyear ending December 2001 are audited by Arthur Andersen, and 0 otherwise;

MAC = market capitalization of the firm calculated as the market value of the equity at theend of June 2002, in trillions of dollars;

MTB = market-to-book ratio of common equity at the end of June 2002. divided by 100;

LEV = debt-to-equity ratio calculated for the fiscal year ended December 2001; and

AUT = audit fee for the fiscal year ending December 2002, in millions of dollars.

* Significant at the O.OI level (two-tailed).

^ Significant at the 0.05 level (two-tailed).

to regulate public accounting firms. The detected abnormal retums for theseevents, except event number 3, are not statistically significant, suggesting thatinvestors did not view the early congressional bills as value-relevant or significantin addressing financial scandals. Tbe SEC proposal (event 3) was considered byinvestors to be an ineffective reform that would allow the accounting professiontoo much infiuence over its proposed regulatory board. Panel B of Table 2 showsthat tbe average daily abnormal retums during tbe ambiguous events period (events1 -4) was negative and statistically insignificant, indicating no market reactions tothese events.

Tbe second category consists of unfavorable events (5, 6, 7, and 8) that eitherdecreased tbe probability of the passage of tbe Act or provided information regard-ing the difficulty of reaching agreement on the final provisions of tbe Act in tbeHouse and the Senate. We detect negative abnormal retums for tbese events, as pre-dicted. Investors viewed tbese events as bad news (unfavorable) and the capitalmarkets reacted negatively to these events. Particularly, tbe average daily incrementalretums on July 9 and 19, 2002 are —2.41 percent and -3.78 percent, respectively,



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which are significant at the 5 percent and the I percent levels. President Bush, onJuly 9, 2002, went to Wall Street and spoke in support of securities law reform,wbich was viewed negatively by market participants (the three-day CAR for botbmodels is negative and statistically significant). On July 19. 2002, there were sig-nificant uncertainties regarding the form, content, and possibility of passage of theAct. This event sent a signal to the market that the Act may not be forthcomingand, as reported, it did not bave much chance of becoming law (Hilzenrath,Weisman, and Vandhei 2002). We detect negative market reactions to this event:daily and cumulative abnormal retums are negative and statistically significant atthe 1 percent level. Panel B of Table 2 indicates tbat the average daily abnormalretums for botb the portfolio of stocks and Value Line index models were negativeand significant at the I percent level (-1.33 and -1.51 percent, respectively) duringthe unfavorable events period (events 5-8).

Tbe last group, consisting of favorable events (9 through 12) unambiguouslyincreased the probability of tbe passage of the Act, and the market reacted posi-tively to these events. Between July 24 and July 30, tbe House and the Senatereached a compromise on legislation, and Congress passed tbe Act by a vote of423-3 in the House and 99-0 in the Senate. The compromised bill was sent to tbepresident to sign into law and was eventually enacted on July 30, 2002. We detectpositive market reactions to tbese favorable events, suggesting that investors viewprovisions of the Act as beneficial to them and important in restoring their confi-dence in corporate govemance, the financial reporting process, and audit functions.Panel B of Table 2 shows tbat the average daily abnormal retums for the portfolioof stocks and Value Line index models during the favorable events period (events9-12) are 1.20 and 3.11 percent, respectively, and both are significant at the 1 percentlevel. Tbe Value Line index abnormal return and the average daily incrementalreturns of the portfolio of S&P 500 companies on July 24, 2002 (Conferencereport) are 4.34 percent and 5.78 percent, respectively, and are statistically significantat tbe I percent level. The market viewed tbe Conference report as a signal of theincreasing likelihood of passage of tbe Act and reacted to this event positively. Thepositive tbree-day CARs for July 25. 26. and 30 during tbe last week of legislativeevents are statistically significant, indicating positive market reactions to these events.

Overall, our results indicate tbat during the ambiguous events period (Febru-ary 14-June 25, 2002) and unfavorable events period (July 9-July 19, 2002), tbecapital markets reacted negatively to related legislative events because investorsfeared either that no bill would be passed or that tbe bill tbat passed would not betough enough to combat the rash of financial scandals. We detect significant positivecumulative abnormal retums during final legislative events leading up to the enact-ment of the Act from July 24 to July 30, 2002 (events 9-12), suggesting tbat inves-tors considered these events as conveying good news in ensuring tbe passage of tbeAct. ^ The magnitude, sign, and significance level of our empirical results are con-firmed by subsequent studies by Li et al. 2004 and Zbang 2(X)5, altbough the latterstudy did not test market reactions to our events 11 and 12 when tbe final bill wassent to the president and subsequently signed into law on July 30. 2002. Zhanginterprets the significant positive CAR on botb July 24 and 25 as "not surprising ...



consistent with the explanation that the final announcement eliminated prior con-cerns for tougher rules" (2005. 20). In the next section, we relate the differences inmarket reaction of different stocks to firm-specific characteristics.

Cross-sectional analysis

Our cross-sectional analysis examines whether the magnitude of positive pricereaction to favorable events leading up to the passage of the Act varies with afirm's corporate govemance characteristics, financial reporting attributes, and auditfunctions. Table 3 reports regression results for each of the four favorable events(events 9-12 of Table 2) and for the entire favorable events period. Each column inTable 3 reports the regression coefficients, standard error, significance level, numberof observations, and adjusted R^.^ The coefficients for the corporate governancevariable {BMSP) are positive and statistically significant. This evidence supportsour hypothesis that companies that were closer to compliance with the corporategovernance provisions of the Act prior to its passage, on average, experiencedgreater positive abnormal security prices. Prior research (e.g.. Shleifer and Vishny1986) documents that large outside blockholders have greater incentives to moni-tor managers. However, we did not detect a statistically significant relationbetween the ownership structure and investor rights (OSIR) variable and theobserved abnormal retums experienced by public companies resulting from thepassage of the Act.

We find that the observed capital-market reactions have a positive and signifi-cant relation with the financial transparency and information disclosure {FTID)variable and a negative and significant association with absolute value of totalaccruals {ATAC). We interpret the negative relation between ATAC and the detectedabnormal returns as implying that the capital markets view firms with higheraccruals as having more opportunities to engage in earnings-management activi-ties. These results suggest that firms with more reliable and transparent financialdisclosures experienced higher positive market reaction around events thai increasedthe likelihood of the passage of the Act.

We find a negative and significant relation between the ratio of nonaudit ser-vice fees to total auditor fees {NATA) and the observed abnormal returns aroundevents leading up to the passage of the Act. Our findings of a negative coefficientfor NATA can be interpreted in two ways. The performance of nonaudit servicessimultaneously with audit services might be viewed by the market as evidence thatauditors' controversial economic bond with their clients could adversely affectaudit credibility. Alternatively, the observed negative association can be interpretedas market participants negatively viewing the loss of the perceived value-enhanc-ing nonaudit services from a firm's close business ally post-Act. As for the impactof an auditor's reputation, we do not find any statistically significant impact ofArthur Andersen audits on the observed capital-market reaction to the Act.

We detect a positive relation between three of the four control variables {MAC,MTB, and LEV) and the observed abnormal retums. The detected positive coeffi-cient for the leverage variable can be interpreted as highly leveraged companiesbenefiting more from the Act's provisions regarding off-balance-sheet transactions,



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possible conflict-of-interest reduction, more control mechanisms, and more effectivecorporate govemance to ensure compliance with the restrictive covenants specifiedin debt agreements. The coefficients for MTB and MAC are positive and signifi-cant, indicating that the market was upgrading larger firms with high growth poten-tial because these firms were perceived (a) to benefit more from those provisions ofthe Act intended to control earnings-management activities; and (b) to be betterable and equipped to absorb high compliance costs of the Act. We detect a negativerelation between the audit fees variable (At/7") as a proxy for the cost of compli-ance with provisions of the Act and the observed capital-market reactions to theAct. The coefficients of AUT are only statistically significant for the events of July24, 25, and 26. This lends support to our prediction that the Act was more costlyfor less compliant firms than for more compliant firms.

Limitations and suggestions for future research

There are a few caveats to our study. First, the Act affects all publicly traded com-panies. Thus, we use the constant-mean retums model to investigate the reaction ofthe entire market portfolio of fimis in the S&P 500 and the Value Line indexes tothe events leading up to the passage of the Act. The test of Hypothesis 1 does notrule oul the possibility that events other than congressional actions could have pro-duced the results. However, searches for confounding events reveal that no otherrelevant event of similar magnitude is known to have occurred around the congres-sional actions. Future research could identify firms not affected by the Act (forexample, similar foreign firms) to carry out experiments with treatment versus con-trol groups. Second, prior studies (e.g., Khanna et al. 2(X)3) caution that S&P scoresare not necessarily proxies for corporate governance. We use other variables (forexample, ATAC and NATA), in addition to the selected S&P scores, to measure thestrength of corporate governance, reliability, and transparency of financial reports.Finally, as with any study of the passage of legislation, our findings should beinterpreted with caution primarily because of the difficulty in identifying (a) thetiming of information about the Act to the market and (b) fimi-specific effects dueto the fact that the Act affects ail firms simultaneously. Future studies could inves-tigate the capital-market reactions to the long-term effects of specific provisions ofthe Act, particularly mandatory intemal control reporting under sections 302 and 4(>4.

6. Conclusion

The Sarbanes-Oxley Act is intended to restore eroded public trust and investorconfidence in financial reports by reinforcing corporate accountability and improv-ing corporate governance, financial reports, and audit functions of public compa-nies. This study examines capital-market reactions to the events leading up to thepassage of the Act. We detect significantly positive (negative) abnormal returnsaround the events that increased (decreased) the probability of the passage of theAct. This suggests that the Act created an environment that promotes strong market-place integrity, and investors considered its enactment as good news. This study alsosheds light on the determinants of the observed market reaction using fimi-specificvariables. We find that more compliant firms with better corporate governance,



reliable and transparent financial reports, and more credible audit functions prior tothe Act were affected more positively by the Act than were other firms. One inter-pretation of this finding is that although the Act equally benefits all firms, itimposes higher costs of compliance on firms with poor govemance and lower dis-closure standards. The Act has served as a stimulus to encourage initiatives forrebuilding investor confidence in corporate governance, financial reporting andaudit functions. Overall, our results suggest that the induced benefits of the Actsignificantly outweigh its imposed compliance costs as measured by stock prices.

Endnotes

1. Turner (2005) argues that the Act has resulted in significant benefits to investors, thecapital markets, and public companies. Indeed, the former chair of the Securities andExchange Commission (SEC), William H. Donaldson, stated that "the Act has effecteddramatic change across corporate America and beyond, and is helping to re-establishinvestor confidence in the integrity of corporate disclosures and linancial reporting"(Donaldson 2005).

2. The WSJI, WSJ, and NYT typically report the press release announcements of theseevents one day after the event date. The announcement dates listed in Table 2 are fromthe SEC and congressional websites. To capture the full impact of these events, we usea three-day event window around event dates.

3. We have developed an analytical model that proves that changes in stock prices werehigher for MC firms than for LC firms after the passage of the Act. Owing to spacelimitations, the model is not presented but is available upon request from the authors.

4. The abnormal retums (daily and cumulative) are standardized over the estimationperiod using the event-induced variance method suggested by Boehmer, Musumeci,andPoulsen 1991.

5. Recent studies (e.g., Khanna, Palepu, and Srinivasan 2003) have employed S&P'sT&D scores as proxies for corporate govemance and financial reporting attributes.

6. The S&P 500 market index produces the same results as the Value Line index.7. We conduct two robustness tests to validate our results. First, we use two alternative

market retum measures of the Russell 1000 and 3000 indexes in addition to S&P 500and Value Line indexes and find that all four market retum measures producequantitatively similar results. Second, we divide our sample into two portfolios of lesscompliant (LC) firms and more compliant {MC) firms, using S&P's FTID scores, andfind that both portfolios experienced net benefits from the passage of the Act, but MCfirms outperformed LC firms.

8. We standardize both the AR and CAR dependent variable in Table 3 over the estimationperiod using the event-induced variance method suggested hy Boehmer et al. 1991.

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CA/f Vol. 23 No. 3 (Fall 2006)

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The Sarbanes-Oxley Act of 2002 and Capital Market Behavior Early Evidence by Jain and Rezaee (2006...

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